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the perspective of the disaggregated regulatory approach with respect to the logical
layer is that there are no network elements which can substantiate market power.
There is no justification for regulation on the logical layer of Internet service provision.
5.5 Analyzing the cost characteristics of the physical layer of the Internet
Network economics shows that monopolistic bottleneck network areas are most
likely to be found on the physical layer of network service provision. The physical
layer by far encompasses the largest investments necessary for Internet service provision. This is not because of high costs for purchasing transmission lines, but rather
because of the substantial expenditures for the first-time installation of these lines.
The large investment cost associated with building a network infrastructure can give
rise to economies of scale and scope in the market. Furthermore, the installation
costs, such as digging trenches and laying cable, are sunk upon entering the market.
The physical layer therefore has a high potential of substantiating stable market
power. Figure 5.1 illustrates the physical layer of Internet service provision.
Figure 5.1: Stylized illustration of the physical layer
Point of Presence: Access point to the
ISPs network
Point of Interconnection between the
networks of the incumbent carrier and
the ISP
Long-distance communications
infrastructure of the ISP
PoP
POI
En
d
U
se
rs
L a
rg
e
cu
st
o
m
er Retail leased lines
PoP
POI
Local loops
Incumbent‘s
long-distance
comm. infrastr.
Collocation sites
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Local communications infrastructure
To connect the end-user’s terminal equipment with the ISP’s network, the ISP needs
to provide for a physical path between the end-user site and its backbone network.
Early in the Internet history is was most common for end-users to use a computer
modem for placing an ordinary telephone call to a local access number of an ISP.
The call would connect the end-user site with a PoP of the ISP’s network on the
basis of local telecommunications infrastructure. From the PoP, the ISP could take
over the transmission of the data, convert the signals of the analog telephone call
into digitized IP format, and forward the IP packets to its packet-switched IP network.
This form of dial-up access has mostly been replaced by broadband access technologies, which offer the end-user far higher download rates from the Internet. For
broadband access to the Internet the end-user site needs to be connected with the
ISP’s network by a high-capacity link. On the basis of telecommunications transmission lines this is most often accomplished by DSL technology. The frequencies of
the phone line are divided into a high-frequency band and a low-frequency band for
Internet and voice traffic respectively. The Internet data transmitted over the highfrequency band are handed over to the ISP at a point of interconnection (POI) between the telephone carrier’s network and the ISP’s network. The ISP can aggregate
the traffic of several DSL72 customers at the POI and forward the traffic via a leased
line or own transmission lines to its backbone network. For larger customers that
generate more Internet traffic it can be economical for the ISP to build out new fiber
cable to the end-user site or at least to connect the end-user site directly via leased
line to its backbone network.
The substantial installation costs involved in laying local communications infrastructure can be divided among only a few end-users attached to the same local
infrastructure. Local lines are therefore characterized by substantial sunk investments per user. Traditionally, the local loop and local leased lines were considered
monopolistic bottlenecks for the provision of voice communication and Internet
services. Economies of scale are generally not exhausted in the local network such
that the duplication of investments into local communications infrastructure is not
economically efficient.
Recently, however, the view that all local transmission lines are monopolistic
bottlenecks has been put into a new perspective by the trend of convergence between
media platforms. The duplication of existing local telecommunications infrastructure
is indeed prohibitively expensive, as long as the economies of scale in the local
infrastructure are not exhausted and the building of alternative local infrastructures
would require incurring substantial sunk investments. However, the investments into
access infrastructure are significantly lower when existing fixed-line local infrastructures are upgraded for the use in local communications services. Internationally,
72 DSL stands for Digital Subscriber Line. DSL is a technology that provides digital data transmission over the wires of a local telephone network and thereby realizes higher download
speeds.
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especially the upgrading of Cable-TV lines (cable-modem access) has been highly
successful.73
Technological advances in wireless access technologies have further expanded
the list of possible substitutes in the local access market which require comparably
low sunk investments in network infrastructure. The currently most established
wireless access technologies are Wireless LAN (W-LAN) and Worldwide Interoperability for Microwave Access (WiMAX). Büllingen and Stamm (2007: 15ff.)
discuss the technical and economical potentials of these technologies. The most
important technical drawback of W-LAN and WiMAX is the fact that the offered
download rates are shared by the number of users in the same access cell. For this
reason, the realized download speed is generally far below DSL standards. The subscription prices for W-LAN and WiMAX are, however, well above the price of DSL
or cable-modem services in metropolitan areas. They can therefore not compete with
DSL and cable-modem access directly. Only in network areas in which DSL or
Cable-access technologies are not available, foremost in rural areas, do wireless
technologies have a chance at commercial success. In these instances, they need to
offer an adequate service at a lower price than would be charged if a DSL or Cableaccess technology were deployed in this region.
A second trend that is dissolving the monopolistic bottleneck in the local access
market is the demand for very high bandwidth connections to the Internet. To meet
this demand, carriers are increasingly investing in the deployment of new fiber lines
closer to end-user sites. Fiber-to-the-home (FTTH) or fiber-to-the-curb (FTTC)
projects are especially prevalent in metropolitan areas. These projects also put competitive pressure on existing infrastructures.
In the face of new alternative technologies for local Internet access (and also
voice telecommunications services), the view that local loops are generally monopolistic bottlenecks can no longer be adhered to. Active or potential competition in
the local loop is very selective (Woroch, 2002). The institutional framework (regulatory environment), technological developments, historical circumstances in which
alternative technologies have evolved, as well as factors such as the population density, all influence the chances of infrastructure-based competition in a particular
local network area. For this reason, it is important that regulation not hamper the
incentives to build out alternative infrastructure whenever this is economically efficient.
For the purposes of the present analysis, it can be concluded that when economies
of scale and scope are not exhausted in the local network area and when offering
alternative access technologies involves making substantial sunk investments, then
the incumbent telecommunications carrier continues to have market power. Sectorspecific regulation is justified in these instances. The regulation of local communi-
73 In Germany, cable-access is only recently gaining market share in telecommunications and
Internet services. This is due to several regulatory and institutional barriers, which delayed
investments into upgrading the cable infrastructure. Büllingen et al. (2007) give an overview
of current prospects of cable-access in Germany.
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cations infrastructure needs to be reevaluated regularly, since technological advances are likely to further expand the realm in which competition is possible.
Long-distance communications infrastructure
As with local communications infrastructure, the installment of long-distance communications infrastructure also involves large fixed investments. Many of these
investments are sunk, such as acquiring rights of way, or labor costs and machinery
costs for burying cable in the ground. Once a network is in place, the variable costs
of operation are relatively small compared to the fixed costs of building a network.
This constellation leads to economies of scale. Also, since long-distance communications lines can be used for more than one kind of service (for instance voice telephony and data transmission), they are , in addition, characterized by economies of
scope.
In the late 1990s the dynamic development of the Internet triggered a surge in
demand for long-distance network capacity. At the capacity limit, marginal cost of
network use rises sharply as capacity expansion becomes necessary. The economies
of scale and scope of long-haul communications infrastructure have, since then,
largely been exhausted. Carriers extrapolated the demand growth for capacity, which
resulted from the exponential growth rates in Internet usage and invested extensively
into long-distance communications infrastructure. Elixmann (2001) gives a comprehensive overview of the international market for long-haul transmission capacity at
this time. The study comprises data on the length of transmission lines, investment
outlays for network capacity, stock exchange capitalization, turnover, and locations
of the most important international carriers for the year 2000.
A study by the OECD (2002) shows that many carriers built end-to-end capacity
linking the major IXs in the U.S. with their respective home networks. As a result,
international IP-traffic today is spread over many networks. Carriers without substantial long-distance communications infrastructure have several options for
purchasing transportation capacity on all major routes. The study also describes that
carriers engage in “capacity swapping” with international partners. European carriers, for instance, use the network of a U.S.-based partner carrier and vice versa
(OECD, 2002: 17).
In conclusion, the market for long-distance communications infrastructure is effectively competitive. There are opportunities both for demand-side substitution as
well as for supply-side substitution, should one carrier restrict output or raise prices
above the competitive level. Regulation of network elements belonging to longdistance communications infrastructure cannot be justified on the basis of the disaggregated regulatory approach.
Co-location
Co-location space is a physical site at which telecommunications carriers install
hardware equipment, such as switches and routers and where network interconnection is realized. Because of the sensitivity of the communications equipment as well
as the high security demands for such a site, co-location facilities afford large
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investments into fire protection, water protection, power supply, air conditioning,
and security provisions.
The large investment costs for setting-up a co-location site give rise to substantial
economies of scale, which only the largest carriers can be expected to exhaust fully.
Furthermore, a large amount of the investment costs for building co-location space
are sunk. Smaller carriers that require far less space for their equipment and expect
to serve fewer customers from a given site are at an economic disadvantage. For
these carriers it is efficient to share co-location space and to distribute the overhead
costs and sunk costs of co-location among several carriers. Lockable racks can ensure that carrier equipment is protected in shared rooms and cabinets.
Whenever ISPs depend on regulated wholesale access to the local access lines of
an incumbent telecommunications carrier, they will also need co-location space at
which to install their hardware and where to realize the physical interconnection
with the incumbent’s network. The amount of space a carrier requires at a given site
is a function of the number of users and the amount of traffic volume, which this site
serves. For choosing the geographical location of a co-location site it is important to
know whether it is likely that several carriers will be present at the prospective site
to share alternative co-location facilities. In cosmopolitan areas, where many carriers
are in need of co-location space and where a high population density allows these
carriers to serve more customers from one collocation site, independent companies
that are specialized in offering shared co-location space to carriers, exist.74 Wherever
such offers are being made, a carrier can rent co-location space scaled to demand.
Compared to the investment costs for building own co-location space, the sunk setup costs involved with using rented co-location space are negligible.
The more rural the co-location site is, the lower will be the number of carriers active in the area, and the smaller the number of users that can potentially be served
from one site. For this reason, independent organizations do not offer scalable colocation space in rural areas. In these areas, only the incumbent telecommunications
carrier will have a high enough demand to justify investments into co-location facilities. Co-location space in rural areas can therefore be a potential monopolistic
bottleneck. In these instances sector-specific regulation is justified that requires the
incumbent telecommunications carrier to offer wholesale access to its co-location
facilities on non-discriminatory terms.
Summary physical layer
The disaggregated analysis of the physical layer suggests that those network elements which are associated with providing long-distance communications are competitive. The network elements associated with offering access services, such as
local loops and co-location space, show different degrees of competition, depending
on the population density in a particular region. Local loops are likely to be compe-
74 Companies such as Interxion (www.interxion.com; site last visited on Feb. 15, 2008) and
Equinix (www.equinix.com; site last visited on Feb. 15, 2008) for example build and operate
Internet exchange centers in large cities worldwide.
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titive when alternative fixed-line infrastructures are present that can be upgraded to
provide Internet services. This is more often the case in metropolitan areas. Alternative co-location facilities are also more likely in metropolitan areas because more
carriers are active there, and more potential customers can be served from one particular site. Monopolistic bottlenecks remain in rural network areas. Sector-specific
regulation is justified whenever local loops and co-location facilities must be considered monopolistic bottlenecks. In these cases, the incumbent carrier should be
obliged to offer non-discriminatory access to its network infrastructure.
5.6 Conclusions
Looking at the market for Internet service provision from the viewpoint of the
disaggregated regulatory approach, this chapter comes to the conclusion that potential monopolistic bottlenecks can be found only in local communications infrastructure. Local access lines, local leased lines, and co-location space can be associated
with economies of scale in the relevant output region and substantial sunk investment costs. These economies of scale have recently been exhausted by upgrading
alternative facilities where this was less costly than setting up an entirely new infrastructure. However, especially in rural areas, local communications infrastructures
often remain monopolistic bottlenecks.
The network elements of the local access infrastructure belong to the physical
layer of Internet service provision and are part of the Internet periphery. Sectorspecific regulation already applies to these network elements insofar as they belong
to traditional telecommunications markets. Regulation of telecommunications markets has taken into account the importance of non-discriminatory access to local
telecommunications infrastructure also for competition in Internet services markets.
Chapter 9 provides an overview of telecommunications regulation in the U.S. and in
Europe and answers the question whether current regulatory practice is sufficient to
guarantee functioning competition in Internet service provision.
The disaggregated analysis of the market for Internet services did not disclose any
regulatory requirements for long-distance network capacity or for core elements of
Internet service provision. These network elements, which are at the center of the
discussion on potential Internet regulation, do not show characteristics of monopolistic bottlenecks. From the analysis of the cost characteristics of Internet service
provision there is no need for ex-ante sector-specific regulation in long-distance
network capacity or in the logical layer of Internet service provision.
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References
Zusammenfassung
Die Konvergenz der Netztechnologien, die dem Internet, der Telekommunikation und dem Kabelfernsehen zu Grunde liegen, wird die Regulierung dieser Märkte grundlegend verändern. In den sogenannten Next Generation Networks werden auch Sprache und Fernsehinhalte über die IP-Technologie des Internets transportiert. Mit den Methoden der angewandten Mikroökonomie untersucht die vorliegende Arbeit, ob eine ex-ante sektorspezifische Regulierung auf den Märkten für Internetdienste wettbewerbsökonomisch begründet ist. Im Mittelpunkt der Analyse stehen die Größen- und Verbundvorteile, die beim Aufbau von Netzinfrastrukturen entstehen, sowie die Netzexternalitäten, die im Internet eine bedeutende Rolle spielen. Die Autorin kommt zu dem Ergebnis, dass in den Kernmärkten der Internet Service Provider keine monopolistischen Engpassbereiche vorliegen, welche eine sektor-spezifische Regulierung notwendig machen würden. Der funktionsfähige Wettbewerb zwischen den ISP setzt jedoch regulierten, diskriminierungsfreien Zugang zu den verbleibenden monopolistischen Engpassbereichen im vorgelagerten Markt für lokale Netzinfrastruktur voraus. Die Untersuchung zeigt den notwendigen Regulierungsumfang in der Internet-Peripherie auf und vergleicht diesen mit der aktuellen Regulierungspraxis auf den Telekommunikationsmärkten in den Vereinigten Staaten und in Europa. Sie richtet sich sowohl an die Praxis (Netzbetreiber, Regulierer und Kartellämter) als auch an die Wissenschaft.